Return of capital now key gauge for retail stocks

NEW YORK (MarketWatch) — As many retailers become more mature and reach their peak growth level, return of capital to investors through either dividends or buybacks has become an increasingly important gauge of how their stocks will fare, a Morgan Stanley report said.

Return of capital to shareholders has become “a critical consideration in stock selection” in the retail industry, Morgan Stanley analysts said in a 23-page report on Wednesday. Return of capital as a percentage of prior-year market cap has risen to mid-single digits over the past two years from 1% to 2% in the earlier part of the decade, they said.

Morgan Stanley described these retailers as being able to “balance robust return of capital with organic growth opportunities and solid returns.”

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Still, the firm cautioned returns of capital shouldn’t be used a sole gauge of stock performance, as in the case of supermarket chain Supervalu Inc.
SVU, +0.33%
, which recently suspended its dividend following disappointing operating results. It advised against stocks such as electronics chain Best Buy Co.
BBY, +0.53%
and Suprevalu rival Safeway Inc.
SWY, +2.50%
with declining cash flows.

“Return of capital can’t be viewed in a vacuum,” Morgan Stanley analysts said in the report, adding they use other measures including revenue, square footage, and profit growth to screen out potential ‘value trap’ stocks.

While increasing dividends and buybacks usually are both positively correlated with a stock’s performance, Morgan Stanley’s research also indicated stocks tend to fare better when a retailer’s capital spending as a percentage of sales is also higher.

That’s “likely related to the growth that retailers and restaurants can stimulate with footprint expansion,” the report said.

Among the different retail sectors, Morgan Stanley said specialty retailers of both hard goods as well as apparel and other soft goods are particularly focused on return of capital, with 31 of 81 retailers under its coverage universe having repurchases and dividends as a percentage of market cap exceeding 15%.

For specific stocks, Morgan Stanley said it thinks VF will likely have a larger than usual dividend hike this year during its third quarter because its dividend is currently below its targeted payout yield.

Natural food grocer Whole Foods Market Inc.
WFM, +0.89%
, which is already sitting on $1.5 billion in cash and other equivalents and marketable securities, or about 20% of its total assets, will likely grow that balance to $2.7 billion, or 31% of its assets by 2015, allowing it to ramp up its dividend or accelerate repurchases, Morgan Stanley said.

Department-store operator Macy’s Inc.
M, -0.39%
may increase its 2013 repurchase significantly as it’s expected to increase its free cash flow by about 50% this year, the report said.

For O’Reilly, Morgan Stanley analysts expect the auto-parts retailer to augment profit growth by repurchasing the amount that’s equal to 10% of its market cap each year, driving about 19% per-share profit growth over the next five years. It said the company, which began its buyback plan in 2011, could repurchase $4.7 billion, or 33% of its shares outstanding, through 2015. It added the retailer also could generate $1.5 billion in incremental sales from expanding in new geographies by 2015.

With the pet supply industry experiencing growth of 5% to 6% over the past five years, Morgan Stanley sees PetSmart well positioned in a growing industry “by the humanization of pets.” It said the retailer also has “a management team that’s committed to a solid return of capital.” It expects PetSmart could maintain $400 million to $500 million in annual repurchases and dividends over the next several years as the retailer could generate a roughly equal amount in free cash flow.

In addition to its industry leading margin and cash flow generation, Limited Brands over the past decade has returned the equivalent of its current market cap to shareholders, Morgan Stanley said.

Limited also raised $1 billion in debt this year, which would give it “ample capital” to increase both capital spending and its repurchase program, which was already expanded by $500 million in February.

On Ann, while the women’s clothing retailer doesn’t pay dividends, it has a “healthy” buyback program “aided by strong free cash flow,” Morgan Stanley said, adding the company has bought back close to $1 billion in stock over the past six years, or more than 30% of its shares outstanding.

For discount retailer Family Dollar, Morgan Stanley analysts said the retailer should see returns move higher as its same-store sales accelerate.

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